How Allocations to Protect Households Can Actually Hurt Them

Posted by jab12004 on June 22, 2009

A previous post gave a small introduction to Local Distribution companies (LDCs) and allowance distribution. I would recommend checking it out since LDC allocation is central to Waxman-Markey. It is so important, that I would wager quite a bit that Waxman-Markey or any climate bill will NOT pass without some sort of LDC allocation built in.

One area which hasn’t received that much attention is how LDC allocation affects the incidence of the policy. LDC allocation is hailed as a method to protect households from higher electricity prices, but ultimately it can make them worse off compared to cap-and-dividend.

A new technical memo that Rich and I worked on finds that the average household could find itself $157 worse off under LDC allocation. This number shrinks to $66 if there is widespread reform of electricity pricing by separating fixed and variable charges, and if industrial and commercial customers respond rationally (more on this in a subsequent post). These values are compared to a full cap-and-dividend, where all permits are auctioned and carbon revenue is redistributed to households through a per-capita dividend.

How could households be worse off under LDC allocation? First, a bit of background. Households feel the burden of climate policy through two large categories: direct expenditure on electricity/heating and indirect costs associated with higher good prices. The direct prices are easy to account for since they are on utility bills, but the indirect costs are a bit trickier. Every good and service you consume has an embedded carbon content due to the energy and emissions associated with its production.

When permits are allocated to LDCs to keep down the direct energy costs, the indirect energy costs a household pays will increase. This increase will ultimately overshadow the savings a household receives from direct energy costs not increasing. So, while under LDC allocation, households might think they are better off since their utility bills aren’t increasing, they ultimately are worse off since everything else in their life is now more expensive.

This result is not exactly what policy makers want to hear. One of the arguments for LDC allocation is to protect electricity consumers. While LDC allocation accomplishes this for direct expenses, it backfires in ultimately protecting households. On the political side of things, it spreads out the household burden of carbon policy and silences enemies of climate policy who simply claim “cap-and-trade makes your utility bills go up.” In the end, this might be what really matters, and the loss in efficiency is just another sacrifice necessary to pass climate policy.